What Remains: Addressing the Ongoing LIBOR Transition
While the first cessation milestone of the London Interbank Offered Rate (“LIBOR”) transition has passed (occurring on December 31, 2021 for GBP, CHF, EUR, and JPY LIBOR, as well as 1-week and 2-month tenors of USD LIBOR), there is a significant amount of work that remains, both addressing the remaining effects of the December 31, 2021 cessation and preparing for the cessation of the remaining tenors of USD LIBOR on June 30, 2023.
Lingering Impacts from the December 31, 2021 Cessation:
Wait… publication of GBP, CHF, EUR, and JPY LIBOR has ceased, how can there be additional work?
- Outstanding instruments that reference GBP or JPY LIBOR: In the fall of 2021, the Financial Conduct Authority (“FCA”) announced (link) that they will require the ICE Benchmark Administration (“IBA”) to publish a “synthetic” version of 1-, 3-, and 6-month settings of GBP and JPY LIBOR for 2022. The FCA clarified that synthetic JPY LIBOR will only be published for 2022 while the decision to continue to publish synthetic GBP LIBOR would be subject to annual renewal. Synthetic LIBOR is meant to be a backstop for the industry in the event that actively converting legacy GBP or JPY LIBOR contracts was not possible in advance of the December 31, 2021 cessation date and the industry was left with contracts that did not have workable fallback language to convert to alternative reference rates (“ARRs”). The FCA did not announce the details on synthetic LIBOR until just a few short weeks before the year end cessation date. This was likely strategic – to encourage firms to continue to actively transition their legacy LIBOR exposure away from LIBOR to ARRs and not rely on synthetic LIBOR. In many ways this worked, however, an unintended consequence was issuers often delayed issuing a consent solicitation in anticipation of what the definition and scope of synthetic LIBOR would be. Because of that, some contracts that may not have been transitioned before the cessation date will likely reference a synthetic LIBOR rate for a period of time. On September 29, 2022, the FCA announced 1- and 6- month synthetic GBP LIBOR will cease to be published after March 31, 2023. Additionally, on November 23, 2022, the FCA announced 3-month synthetic GBP LIBOR will continue to be published until March 31, 2024, after which it will also cease permanently. Given these announcements from the FCA, we anticipate most issuers and holders of remaining GBP LIBOR contracts will look to remediate them through consent solicitation or otherwise in 2023.
- Asset Class Considerations: Some securities, such as contingent convertible bonds with a fixed-to-float rate structure, currently reference a fixed rate until a defined date, but then move to a floating rate (e.g., LIBOR). In this case, there continues to be the possibility of future LIBOR exposure once the security moves to a floating rate given the way the contract is structured. Most of these contracts are callable by the issuer and will likely be redeemed at their next call date, which is when the contract would transition to a floating rate. Issuers are incentivized to call these instruments for a variety of reasons including unfavorable spreads, loss of favorable capital treatment, and refinancing opportunities. Other contracts are expected to be amended in 2022 through consent solicitation, exchange offers or other activities. Additionally, for passive investment managers, when fixed-to-float instruments are held within an index, they often fall out of the index when the instrument's reference rate transitions to a floating rate per the index methodology. While outside a passive investment manager’s control, this reduces risk related to LIBOR exposure that is driven by a fund’s investment, and lack of management discretion, in an index.
- Fallback Language Operationalization: Despite the first LIBOR cessation date occurring on December 31, 2021, that does not mean that a contract with fallback language that specifies a replacement rate will move to the replacement rate at that point in time. Instead, the effects of the rate change are felt on the contract’s first reset or coupon date, when interest is paid on the contract (and thus uses the contract’s specified interest rate to calculate interest). These reset dates are not uniform across instruments and could go months out into 2022 depending on the tenor of LIBOR being used (e.g., 6-month LIBOR may not reset until 6 months into 2022). In addition, fallback language is not consistent across contracts due to factors such as when a contract was issued. Contracts issued before 2019 tend to have less precise and, in some cases, unworkable fallback language. Firms need to be careful to ensure fallback language provisions are accurately followed and the rate is appropriately implemented into ongoing interest rate calculations. This can be complex in cases where the fallback language specifies a new rate that may not be available, such as moving to a rate based on panel bank submissions of LIBOR (typically with a minimum amount of panel bank submissions required). In this case, synthetic LIBOR is an effective temporary backstop but that further necessitates the importance of an active transition away from LIBOR.
Preparing for the June 30, 2023 Cessation Milestone
Beyond the December 31, 2021 cessation milestone, significant preparation for USD LIBOR cessation on June 30, 2023 is required due to the significant industry-wide use of the outgoing rate. Because of this, applying lessons learned from the first LIBOR cessation milestone for non-USD currencies will be critical in successfully transitioning away from USD LIBOR. Below are a few of the key areas of focus in preparing for the USD LIBOR transition:
- New Use of USD LIBOR: The FCA announced that new issuances of USD LIBOR referencing instruments are prohibited starting in 2022 (link). This prohibition applies to the financial services firms and financial markets in the UK that fall within its supervisory authority. Importantly, this is only for new primary market USD LIBOR issuances after December 31, 2021, not trading of existing (or secondary) USD LIBOR referencing securities issued prior to year-end. In the US, regulators and working groups have shared guidance that banks should no longer issue USD LIBOR referencing instruments after December 31, 2021 (link). It remains to be seen if this will fully actualize, given the omnipresence of USD LIBOR in financial markets and the delay in SOFR liquidity, most notably in cash markets. There remain certain scenarios where acquiring new USD LIBOR referencing contracts could be necessary, such as hedging or other transactions designed to reduce total LIBOR exposure. While the market is clearly moving away from USD LIBOR, there are important nuances to the new use restrictions on USD LIBOR that may lead to increases in USD LIBOR exposure (e.g., trading into an offsetting LIBOR swap to synthetically unwind an existing LIBOR swap).
- Term SOFR: While Term SOFR was endorsed in late July by the Alternative Reference Rate Committee (ARRC), the licensing process to allow firms to have the ability to trade Term SOFR has been extended for certain firms, resulting in delays of Term SOFR adoption. The broader availability of Term SOFR is important in accelerating the transition away from USD LIBOR for many reasons, most notably that it is the first rate in the ARRC’s recommended fallback language waterfall (i.e., contract moves to Term SOFR plus the ISDA 5 year historical median spread adjustment, set on March 5, 2021 (link), upon a trigger event such as LIBOR cessation). The ARRC’s fallback language waterfall is applicable to bilateral business loans, adjustable-rate mortgages, floating rate notes, securitizations, syndicated loans and variable rate private student loans. Term SOFR is also a forward-looking rate, thus functioning more similarly to LIBOR. There are notable drawbacks, such as challenges in hedging, but Term SOFR is likely to become a viable USD LIBOR alternative, particularly in certain asset classes such as the bilateral loans market.
- Adoption of SOFR and the Possibility of Credit Sensitive Rates: The ISDA Clarus RFR Adoption Indicator (link) shows SOFR liquidity to have increased substantially in the fall of 2021, as a result of the Commodity Futures Trading Commission’s SOFR First Initiative (link) that switched trading conventions from LIBOR to SOFR in phases for linear interest rate swaps, cross currency swaps, non-linear derivatives and exchange traded derivatives. Additionally, regulators have denounced credit sensitive rate alternatives to LIBOR (link), such as Bloomberg Short-Term Bank Yield Index (BSBY) and Ameribor, among others, for their lack of robust underlying markets and similar drawbacks to LIBOR. The confluence of these factors has dampened industry excitement related to credit sensitive rates, initially sought out due to the rate construction being more closely aligned to banks cost of funding, particularly during times of economic volatility. Given that new issuances of USD LIBOR referencing securities are expected to cease starting on January 1, 2022, the market will need to determine what alternative rate is preferred. Coalescing to a single market wide benchmark rate has benefits, as SEC chair Gary Gensler recently noted in a recent ARRC SOFR Symposium, but it seems unlikely that the market will have a rate as dominant as USD LIBOR moving forward. This requires a continued reassessment of the broader market transition to ARRs to inform ongoing investment decision making.
- Federal Legislative Solution for Tough Legacy Contracts: As we enter 2023, there is still a substantial amount of outstanding exposure to USD LIBOR. In March 2022, US federal LIBOR legislation was enacted as part of the fiscal year 2022 omnibus appropriations act. The legislation is titled the ADJUSTABLE INTEREST RATE (LIBOR) ACT (Bill Text, LIBOR legislation appears on pages 1954-1978). The legislation was signed into law on March 12, 2022, by President Biden. The purpose of the legislation is:
- To establish a clear and uniform process, on a nationwide basis, for replacing LIBOR in existing contracts the terms of which do not provide for the use of a clearly defined or practicable replacement benchmark rate, without affecting the ability of parties to use any appropriate benchmark rate in new contracts
- To preclude litigation related to existing LIBOR contracts the terms of which do not provide for the use of a clearly defined or practicable replacement benchmark rate
- To allow existing contracts that reference LIBOR but provide for the use of a clearly defined and practicable replacement rate to operate according to their terms
- To address LIBOR references in certain Federal laws
On December 16, 2022, the Board of Governors of the Federal Reserve System issued the final rules for implementing the LIBOR Act. The final rule establishes benchmark replacements for contracts governed by U.S. law that reference certain tenors of U.S. dollar LIBOR (the overnight and one-, three-, six-, and 12-month tenors) and that do not have terms that provide for the use of a clearly defined and practicable replacement benchmark rate following the first London banking day after June 30, 2023. The final rules also specify what type of contracts are covered under the LIBOR Act.
The types of contracts covered under the LIBOR Act include:
- LIBOR contracts that contain:
- No fallback language
- Fallback language with references to LIBOR
- Fallback language with references to polling
- LIBOR contracts that contain fallback language that does not identify a specific benchmark replacement or determining person
- LIBOR contracts that contain fallback language that identifies a determining person, but the determining person has failed to select a benchmark replacement by the earlier of the LIBOR replacement date and the latest date for selecting a benchmark replacement according to the terms of the LIBOR contract
The board-selected benchmark replacement rates differ based on the type of contract. For each contract type, the type of SOFR and spread adjustment selected by the board are as follows:
- Derivatives
- SOFR compounded in arrears + tenor spread adjustment
- Cash – non-consumer loans and non-Government Sponsored Entities
- Term SOFR + tenor spread adjustment
- Consumer loans (one-year phase in)
- Term SOFR + transition tenor spread adjustment or
- Refinitiv’s USD IBOR Cash Fallbacks rate
- Federal House Finance Authority regulated
- 30-day average SOFR + tenor spread adjustment
- Federal Home Loan Bank Advance
- SOFR compounded in arrears + tenor spread adjustment
- Federal Family Education Loan Program Asset Backed Securities
- 30-day average SOFR (for 1m, 6m, 12m USD LIBOR) + tenor spread adjustment
- 90-day average SOFR (for 3m USD LIBOR) + tenor spread adjustment
While a lot of the hard work has been done across the financial services industry in preparing for the initial LIBOR cessation date of December 31, 2021, it is clear that there is still much to be done before we can live in a world without LIBOR. There is significant global exposure to USD LIBOR that needs to transition and, as we have discovered so far, it is not as simple as replacing a lightbulb. Preparing for LIBOR cessation has in many ways been like re-wiring the house without turning the electricity off. We have learned a tremendous amount since the December 31, 2021, cessation and as we enter the final stretch, we are now much better place to see off LIBOR.
Recap of LIBOR and IBOR Cessation Dates
Invesco continues to actively monitor the industry wide move away from LIBOR, including guidance from working groups and regulators, in informing the transition plan. The LIBOR transition has been a multi-year effort and Invesco will continue to work on supporting clients through this monumental journey.
Below is a table that shows the status of cessation of various forms of LIBOR and IBOR. For further information on Invesco’s efforts to address the LIBOR transition, please visit the frequently asked question section of the website (link) or reach out to your client relationship manager for more information.
